When can fixed overhead costs be a part of a claim for loss of profit?

17 Sep 2010

When can fixed overhead costs be a part of a claim for loss of profit?

by Victor Lau

Loss of profits (for breach of contract pleaded as expectation damages) will be quantified by taking into account and deducting relevant indirect or overhead costs.

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Put simply, in a claim for damages for loss of profit for expectation damages, "profit = revenue - costs". But are fixed overhead costs to be included as "costs"?

Fixed overhead costs typically include expenses for maintaining an office, insurances, utility bills and paying head office staff. The inclusion of fixed overhead costs would of course increase the overall costs, thereby reducing the amount of profit that can be claimed.

The recent case of North Sydney Leagues' Club Ltd v Synergy Protection Agency Pty Ltd [2010] NSWSC 256 confirmed that in determining "net profit" by reason of breach by the other party, fixed overhead costs should be taken into account. As a result this reduced the amount that Synergy was able to recover.

The court suggested that the result may have been different if Synergy had framed its damages case differently. This is because a claim for damages for breach of contract may be pursued on a number of different assessment bases. Whilst ultimately the method for assessing damages is a matter for the court, a party may pursue a claim on more than one assessment basis, provided it is not put in a better position than if the contract had been performed.

The contract and the dispute

North Sydney Leagues’ Club Ltd entered into several contracts with Synergy Protection Agency Pty Ltd for the provision of security services by Synergy to Norths at the club's premises in Sydney and Tweed Heads.

The core of the dispute was the extent to which the contracts in question required Norths to use Synergy to supply security services at the clubs. Norths’ position was that it had freedom to call on Synergy as much or as little, as it liked, and if it chose to use others to supply security services it would not be in breach of its contracts. Synergy, on the other hand, contended that the contracts required Norths to use it exclusively to provide the services.

Norths was found to have breached the relevant contracts and Synergy sought damages for an amount equivalent to the total contract payments it would have received, less its direct costs of obtaining the payments, which were essentially wages to security guards. In doing so, Synergy sought what is known as "expectation damages", where the injured party is put back in the same position as if the breach had not occurred.

Calculating the damages

In quantifying the damages, the only dispute between the parties was whether some proportion of the overhead costs should be taken into account as expenses, to be set off against revenue in the calculation of "net profits".

The court held that fixed overhead costs should be taken into account in determining net profit. The key points made by the court were that there is:

no basis to assume that all fixed overheads were to be paid from revenue streams from other contracts, but not from the Norths contracts; and

no reason why the approach should be different to the reverse, in situations where contractors are often able to recover unabsorbed head office overheads for damages for delay. Such claims are on the basis that head office costs would continue but the revenue stream does not continue because of the principal's delay.

As to how the fixed overhead costs are to be accounted is ultimately a matter of evidence. The court referred to a decision of the High Court in Dart Industries Inc v Décor Corporation Pty Ltd (1993) 179 CLR 101, in respect of a dispute concerning the production and sale of a product that infringed a party's patent. It was noted in this High Court case that the relevant considerations for accounting for overheads included whether:

the relevant overheads were increased by the manufacture or sale of the product;

they represent costs which would have been reduced;

they represent costs which would have been incurred in any event;

they were surplus capacity; or

would, in the absence of the infringing product, have been used in the manufacture or sale of other products.

Generally, it seems that courts would have regard to the nature of the costs and how they relate to the project or transaction in question.

Synergy put its case for damages solely on the basis that it sought recovery of "net profits" only, or expectation damages. On that basis alone, the court held that some proportion of Synergy's overhead costs have to be brought into account as expenses, to be set off against revenue in the calculation of "net profits". As noted by the court, the problem for Synergy was that it did not plead any alternative case for damages in the event that its construction of the contracts was rejected.

The other basis for assessment of damages is typically framed as "reliance damages", whereby a party seeks damages on the basis that it would not have incurred certain of the costs which it incurred but for the breach of the contract. Synergy did not argue a case claiming reliance damages.

Comparison with contractors' claims for overheads

While the court in the Norths case compared this issue with a contractor's claim for recovery of overheads due to delay, under some contracts a contractor's entitlement to claim for delay is restricted to "extra costs" only. The extent to which such overhead amounts are recoverable under such contracts by the contractor will depend on whether the overheads are extra costs or loss.

A loss might arise because the same overheads (for example, rent and utility bills) will be incurred without the anticipated income to defray them. This loss may not be recovered under a contract that restricts recovery for "extra costs" only.

Conclusion

The Norths case supports the conclusion that loss of profits (for breach of contract pleaded as expectation damages) will be quantified by taking into account and deducting relevant indirect or overhead costs.

In seeking damages for breach of contract, it is important to frame your case appropriately. If you don't, your ability to recover the full amount entitled under the law could be unnecessarily limited.

It is also important to identify the amounts and the nature of each of the overhead costs and how they relate to the project or transaction in question, so that the relevant quantifications can be suitably carried out. Professional expert assistance is recommended.

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.